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As M&A Season Heats Up, 3 Sectors To Target

For much of the past five years, many companies have been squarely focused on their own operations, using excess cash to pay dividends, buy back stock, or reduce debt -- the three pillars of what we call Total Yield.

Look for more of the same in 2014, as companies continue to generate stunning amounts of cash flow.

And also look for a lot more deal-making in the year ahead. The conditions are ripe for a boom in mergers and acquisitions (M&A), and various sectors will really heat up as the deals flow.
On the face of it, companies appear to continue shunning major mergers and acquisitions. The economic crisis in 2008 and 2009 left many firms feeling too cautious to make bold moves. But some of that caution was shed in 2013.

According to ThomsonReuters, the total dollar value of all M&A activity in the U.S. rose 11% last year, to more than $1 trillion. The sectors and industries that saw the most action were oil and gas ($227 billion), wireless telecom ($175 billion), commercial real estate ($161 billion), and metals and mining ($93 billion).

Looking at the macroeconomic backdrop, a case can be made for even more deal-making in 2014. The economy is stable, which reduces the risk that a deal will come at a time when business trends are weakening. Borrowing costs, though up a bit from a year ago, remain far below levels seen in recent decades. Companies are seeking out new industry niches for expansion, and buying a leading niche player can yield an instant presence.

Perhaps most important, the economy won't be growing fast enough for companies to meaningfully boost sales and profits on an organic basis, and executives know that their stock options will only rise sharply in value if investors are provided with a meaningful growth strategy.

Where Will The Action Be?
We already know that some industries will keep consolidating. The wireless telecom industry, for example, is in the midst of a merger frenzy that will eventually likely leave just the biggest three firms in place. For instance, T-Mobile (Nasdaq: TMUS) is likely to be acquired in a matter of days or weeks. (My colleague Joseph Hogue recently examined this trend and suggested an under-the-radar side play.)

Gold and silver miners are also likely to seek deals. Cash-rich, low-cost producers are already looking at vulnerable targets that have neither the balance sheet nor the cost structure to ride out the current wave of lower precious metals prices. Potential acquires include Goldcorp (NYSE: GG), Yamana Gold (NYSE: AUY) and New Gold (NYSE: NGD), all of which have below-average mining costs and solid cash balances.

Miners that may be targeted (as they trade at or below book value) include:

The Pipeline Replenishment
Major drug and biotech companies maintain large sales forces, and they need to make sure their peddlers have enough drugs to peddle. So they're constantly on the prowl for smaller drug firms that may be closing in on FDA approval.

Technology's Star Power
Investors are increasingly focusing on tech companies with strong niches and/or high growth rates. For example, Big Data firms Splunk (Nasdaq: SPLK) and Tableau Software (Nasdaq: DATA) both trade for more than 15 times trailing sales. Firms like these can use their inflated stock to acquire smaller niche rivals that help extend their technology platforms. That was the decade-long strategy deployed by EMC (NYSE: EMC) to great success.

Of course, you can count on the industry's biggest players to also write large checks. Google (Nasdaq: GOOG), Apple (Nasdaq: AAPL) and Microsoft (Nasdaq: MSFT) have all stepped up their pace of deal-making in recent years, and their cash-rich balance sheets imply more deals ahead. They'll be looking for smaller tech firms that have appealing niches and reasonable valuations. Here's a look at tech firms that have lost momentum in recent quarters and could be acquisition targets in 2014.

Risks to Consider: Robust M&A always comes when the economy is at least stable, so any renewed economic weakness, either in the U.S. or globally, would lead companies to avoid the risk-taking that comes with acquisitions.

Action to Take --> You don't need to focus on specific companies that may be acquisition targets -- you can focus on the industries instead. Once a deal or two is announced in a specific niche, then all of the stocks in that niche can be bid up, either because the apples-to-apples comparisons show that rivals are now undervalued, or because investors are speculating on which firm will be next. Whenever you hear of a deal announcement, it pays to move quickly and research the competitors in that space, as their shares may also soon benefit from M&A speculation.